Exploiting the Low Volatility Anomaly: A High Yield Bond Example

Share

Kensington Wealth Advisors has a unique edge;

For over 25 years, we have exploited the Low Volatility Anomaly and the Momentum Anomaly, which has been a successful repeatable process for our clients. The month of July resulted in solid gains for our strategy. We have expanded the information on the Low Volatility Anomaly for your review below:

Exploiting the Low Volatility Anomaly: A High Yield Bond Example

Summary

This article provides a broad look at the Low Volatility Anomaly, or why lower risk securities have historically produced stronger risk-adjusted returns than higher risk securities or the broader market.

This article extends the historical evidence of the outperformance of lower volatility securities to the fixed income universe.

Demonstrating the success of low volatility strategies across markets should add credence to the notion of the strategy’s long-run success.

A factor tilt towards the lower volatility components of the S&P 500 (NYSEARCA:SPY) would have outperformed both the broader market and higher beta stocks on both an absolute and risk-adjusted basis over the last quarter century. While the period from late 1990 to early 2015 used in the comparison between the Low Volatility (NYSEARCA:SPLV) and High Beta (NYSEARCA:SPHB) sub-indices of the S&P 500 featured three domestic recessions and two historically large equity market drawdowns, the outperformance of low volatility stocks raises the question about whether lower volatility bonds should have also outperformed higher volatility bonds, especially given the asymmetric nature of bond returns.

While the discussion of the “Low Volatility Anomaly” in public equities has become increasingly documented and discussed in the financial press, less research has been done regarding whether this phenomenon exists in credit investing. In February 2013, Andrea Frazzini and Lasse Heje Pedersen, researchers associated with hedge fund AQR Capital Management, released an updated version of their 2010 paper “Betting Against Beta.” Readers of the entire series will note that these authors also contributed to the Buffett’s Alpha paper detailed in my last article that demonstrates a strong correlation between low volatility strategies and the success of Warren Buffett’s investing style at Berkshire Hathaway (BRK.A, BRK.B). The authors demonstrated that across investors, geographies, and time, constrained investors bid up high beta assets to levels that should be inconsistent with their necessarily higher risk. Since high beta assets are therefore associated with low alpha, a portfolio that is long leveraged low beta assets and short high beta assets generates meaningful excess returns.

In “Betting Against Beta”, the authors examined returns from January 1973 to March 2012 for the Barclays U.S. Corporate Index. The table below details the historical results. Returns and alpha are in monthly percent. T-statistics are shown below the coefficient estimates with 5% statistical significance denoted in bold. Volatilities and Sharpe ratios are annualized.

The “Low Volatility Anomaly” is readily apparent in historical corporate bond returns. While volatility rises as we move down the ratings stack (from left to right in the graph), excess returns do not, as single-B and lower rated bonds produce lower alphas and worse Sharpe ratios than investment grade bonds.

The meaningful alpha generated by the authors’ Betting Against Beta factor (BAB factor), depicted in the column at the far right of the box, is consistent with the notion that high volatility corporate bonds do not produce returns consistent with their higher risk. To construct the zero beta BAB factor, the authors assigned bonds to two portfolios – low beta and high beta. For the low beta portfolio, the bonds were then rank ordered in ascending fashion by beta with low beta bonds receiving higher weights. For the high beta portfolio, the opposite approach is taken with the bonds rank ordered in descending fashion by beta with high beta bonds receiving higher weights. The portfolios are rebalanced monthly, and rescaled to have a beta of 1 at portfolio formation. A leveraged portfolio of high-rated, low beta corporate bonds outperformed a de-leveraged portfolio of lower-rated, high beta corporate bonds over the sample period.

Credits rated at the bottom of the ratings spectrum are almost universally characterized as having higher leverage, a ratio of debt to earnings. Leverage constrained investors who choose to go down in credit quality by lending to companies with higher embedded leverage would likely be better served by adding external leverage to higher quality credits. This relationship is akin to the earlier description of the S&P 500 Low Volatility Index producing higher risk-adjusted returns than the S&P 500 High Beta index. High beta assets in both equities and credit have been characterized by low alpha for very long-time intervals.

A separate view of the “Low Volatility Anomaly” in the fixed income universe is evident through an examination of historical annual total returns of the Aaa – Baa rating components of the Barclays U.S. Corporate Investment Grade Index and the Ba – Caa rating components of the Barclays U.S. High Yield Index detailed below:

While the standard deviation of annual returns rises as you move down the ratings spectrum, realized annual returns for triple-CCC rated bonds are below that of any other ratings cohort as realized credit losses more than offset the historic spread premium. With the traditional caveat that historical returns are not a guarantee of future results, leveraging lower volatility, higher rated, less levered corporate bonds would produce long-run alpha.

Echoing a conclusion, I reached in The High Yield Bond Trade for the Long Run, being overweight BB rated bonds or funds that are more heavily allocated to this highest rated cohort of below investment grade have historically outperformed lower rated and riskier securities despite those securities higher yield because they have generated lower realized defaults over time.

To this point, this series has focused primarily on empirical evidence of the Low Volatility anomaly in the equity market, but I hope this fixed income example demonstrates its relevance across markets. The next article in this series will demonstrate a successful strategy that intersects the equity and fixed income markets.

Sign up for our newsletter

DISCLOSURE
Kensington Wealth Advisors, LLC (“Kensington”) is an SEC registered investment adviser located in Richmond, Texas. Kensington is registered with the Securities and Exchange Commission (“SEC”) as an investment adviser under the Investment Advisers Act of 1940, as amended. All information contained herein is for informational purposes and should not be construed as investment advice. It does not constitute an offer, solicitation or recommendation to purchase any security or investment advisory services nor shall any such security or investment advisory service be offered or sold to any person in any jurisdiction in which such offer, solicitation, recommendation, purchase or sale would be unlawful under the securities laws of such jurisdiction. For more detailed information about Kensington’s business operations, advisory services and fees, please request the firm’s Form ADV Parts 1 and 2A, which is also publicly available on the SEC’s website.